Last Updated on October 1, 2023 at 5:38 pm
What factors should we consider before choosing a mutual fund or evaluating a mutual that we hold? Should we only look at star ratings? Should we consider only returns? Risk-adjusted returns perhaps? Should we track the actions of the fund manager? Should I understand the kind of stocks that he/she has picked or is likely to pick? Such questions drift past our minds from time to time.
In this post let us look at some quantitative and qualitative methods of analysing mutual funds. Obviously, we need both types of analysis before choosing a fund or evaluating a fund holding. The extent to which we use each type depends on our aptitude and experience.
We will also look at the bare minimum knowledge of each type necessary for the newbie investor or the typical retail investor.
Quantitative analysis is the study of easily accessible and perhaps tangible information associated with a mutual fund. This is most often the NAV history, which is compared with its benchmark history in several ways.
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Quantitative analysis treats the mutual fund like a black box. Funds are clubbed together based on the market cap of the portfolio and relative performance is evaluated.
All star ratings fall under this category.
The style of investing (for e.g. Growth stocks or Value stocks – see below) is not explicitly taken into account in the analysis. However the fund categories take care of that to a certain extent. For example, large cap funds typically have majority of growth stocks in their portfolio.
We can say nothing about the future performance of the fund as we only use past data (NAV history).
We can however evaluate past performance in different ways:
- Absolute volatility (standard deviation) and volatility relative to the benchmark (beta) (see this for more details)
- Correlate NAV movement with benchmark movement (R-squared). For example, holding two funds with high R-squared wrt the same benchmark is diworsification.
- Compare SIP and Lump sum returns wrt benchmark (See: Returns analyzer)
- Evaluate returns by taking into account the associated risk in different ways (See: Risk and returns analyzer)
- Calculate consistency in performance (See: Rolling returns analyzer)
- Estimate investor stress while holding the fund (See: Ulcer Index analysis)
- Calculate relative performance during market highs and market lows (See: upside/downside analysis)
There are many more methods, which we shall hopefully discuss in the future.
We pay so much attention to past performance because pedigree is important to us. We do not want to invest our money in an unknown fund.
Of course, it is important to keep in mind that good pedigree does not mean good performance in the future.
While quantitative methods help build investor confidence while choosing a fund, they are vital while evaluating a holding and for portfolio analysis.
If our portfolio return sudden changes (either positively or negatively), quantitative methods help us to locate the hero or culprit and more importantly, the extent of outperformance or underperformance, as the case maybe.
However, identifying and analyzing culprits (assuming heroes are not analyzed like in the current bull run!) is one thing. Exiting a fund or stopping investments based on this data is quite another.
One should not exit the fund unless we are clear about the investment strategy, the nature of stocks in the portfolio, the market outlook (and of course, when we need the money). The fund managers track record during a market cycle, and the AMCs pedigree in terms of strategy are also important.
Also, while choosing a fund, it is important to understand what kind of fund it is. What is the investment strategy. If an identical fund exists in the portfolio. Will the portfolio become more diversified if we buy this fund.
This is where qualitative analysis helps us make better decisions.
Qualitative analysis is the study of the internal machinery associated with a mutual fund. The nature of the portfolio. The type of stocks chosen. How often the fund manager makes changes. The overlap with the benchmark. What is the strategy of the fund? Has it remained true to its mandate. Has the stock-picking style changed with fund manager (or fund house after a take-over or merger!).The pedigree of fund house.
Both methods use mathematics. The word qualitative does not imply that math is not used!
For example, a fund is classified as a ‘growth fund’ or ‘value fund’ by studying the price-to-earnings (PE) and price-to-book (PB) ratios of the stocks in the portfolio.
Growth stocks are those which are expected to grow at a faster pace than the market. They belong to established companies. They typically have higher PE and PB ratios than value stocks. Value stocks are potential growth stocks. That is they are available at prices much lower than what investors think they are worth.
The simplest qualitative method an investor encounters is the classification of funds on the basis of market capitalization: large cap, mid/small-cap, multicap, large and mid-cap etc.
Within each category the nature of the stocks can be found out by looking the fund style box.
Morning Stars equity style box looks like this. Value Research online also has a similar style box.
Debt fund style boxes have interest rate sensitivity and credit quality instead of market cap and stock type.
Some investors believe they should hold 2/3 large cap funds and 1/3 small/mid-cap funds in the hope of reducing downside risk. This thinking is devoid of logic.
Not only might the funds have significant overlap of actual stocks, they would also have significant overlap in investment styles. So this is just diworsification. Keeping it simple when it comes to portfolio construction is vital to portfolio health (see below).
Many aspects of qualitative analysis require knowledge of the fund portfolio and its history.
The performance of the fund manager can be dissected in many ways. Was his/her success a result of intelligent decisions or luck? Which sectors in the portfolio resulted in the highest gains. Which sectors or stocks led to the biggest fall etc.
This is known as attribution analysis.
Here is a write up on the subject by those who run thefundoo.com. This analysis is available for premium subscribers (typically advisors) at thefundoo.com. Update: Fundoo CEO, Sharad Singh just announced in FB group, asan ideas for wealth that attribution analysis is also available free from today!
The extent of active management can be determined in various ways. While all of them are in terms of numbers, some require knowledge of the portfolio. Active Share is one such measure. I would therefore classify it as a qualitative method.
To quote investopedia,
Active Share is a measure of the percentage of stock holdings in a manager’s portfolio that differ from the benchmark index.
….managers with high Active Share outperform their benchmark indexes and that Active Share significantly predicts fund performance.
I am more of a quantitative person and don’t know more about qualitative methods. Hope to learn and write more on this in the future.
One of my personal finance influencers, Ramesh Mangal is partial to qualitative analysis. Anyone who has read his comments in the facebook group, Asan Ideas for Wealth will testify to that.
Here is a qualitative approach to fund selection: How to Select a Mutual Fund – Expanded Guidelines
Vidya Bala of FundsIndia does a commendable job of balancing both approaches well. As long as one does not tinker with ones portfolio each time she reviews an NFO or makes changes to their ‘select funds’ list, one can learn much from her writings.
Value Research Online offers only quantitative analysis (star ratings). Morning Star India offers both: Star ratings and what they call analyst ratings.
The analyst ratings vary from Gold (best), Silver, Bronze, Neutral to Negative (worst).
The analyst rating is a qualitative analysis in which they evaluate the future potential for outperformance. More about this here and here
Amusingly I once found a five star-rated fund with a negative analyst rating!
While an analyst rating should not be used in isolation, I will stick my neck out and say that I find it much more level-headed than star ratings.
When HDFC Top 200 and HDFC Equity was underperforming (relative to other funds), investors were all ready to quit them. Morning Star analyst ratings urged them to remain calm keep the faith.
When Reliance Growth underperformed, Morning Star analyst research pointed to a change in character of the fund (more large cap exposure possibly because of fund size). If I am not wrong, they downgraded the rating to neutral.
Such a negative review, combined with poor performance (see quantitative analysis here) is enough to exit the fund. NAV is just a number. It is irrelevant to me that funds NAV has climbed to 700.
Unfortunately, like star ratings, analyst ratings is not available for all funds. I am not happy with Morning Star in this regard. They seem to pick and choose funds that they want to qualitatively analyze.
What should a newbie investor or the typical retail investor do?
Obviously use both strategies. However, there is hardly any need to go in-depth either qualitatively or quantitatively.
Here is a set of simple steps that one can adopt.
1) Quantitative:
- Understand what the standard deviation is.
- Understand how it is the key to successful mutual fund investing.
- Understand how it can be used to choose mutual fund categories suitable for financial goals.
2) Qualitative:
- Once the categories are finalized, the asset allocation according to the risk profile has to be decided. Refer to this if you need help: A Step-By-Step Guide to Long Term Goal-Based Investing
- Then a suitable portfolio diversified within each asset class must be decided. This helps us identify the class of funds within each category (large cap, mid-cap etc.).
3) Quantitative:
- Now we are ready to shop within each fund class.
- Identify consistent performers as outlined in the guide to choose mutual funds and choose one.
- Interested investors can further evaluate the consistency of performance using the Rolling returns analyzer and eight year risk adjusted return performance
4) Qualitative:
- If we keep it simple, either choose a single balanced fund or just one large-cap fund and one small/mid-cap fund or just one large and mid-cap fund, we do not have to worry about investing styles of the funds.
- The pedigree of the fund house is important to an extent (Morning Stars analyst research of any fund from that fund house can be used for this). The tenure of the fund manager is also important. If a new fund manager has just taken over, should I choose the fund(?), is a reasonable question. Tough to answer though. Some funds are independent of fund managers. The fund house has a clear mandate and the manager usually follows this. Typically such managers are not stars. Some fund houses seem to rely on one person a little too much. Not sure if that is good or bad. Perhaps a star fund house is better than a star fund manager.
I think that should do for choosing a good fund or evaluating an existing holding. Believe me, it is easier that it appears.
Any prolonged underperformance must be taken seriously. Qualitative methods gain importance during such times since a decision (hold/buy/sell) will have to be taken.
Which is why it is always a good idea to collect the monthly portfolios of the funds that you hold and stare at them from time to time!
Phew! What do you think?
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